Futures

Futures

A future or futures contract is a standardized agreement to buy or to sell an asset (the underlying) at a certain future time (settlement date) for a prearranged price (the future price). One of the two parties of a futures contract holds the so-called long position, that is, to buy the underlying.

The other position is called the short position. A futures contract itself is traded and listed on a futures exchange. This contrasts it with a forward contract that is not standardized and is done on an over-the-counter basis.

Futures contracts are always binding for both parties of the contract. This differentiates futures from options contracts where only one party, the option writer, is obliged to fulfill the contract, while the other party, the option holder, has the option but not the obligation to buy or sell.

There are two important classes of underlyings that can be identified: commodities and financial assets. Typical commodities that underlie futures contracts are pork, live cattle, sugar, wool, lumber, copper, aluminum, wool, and tin. Typical financial assets include stock indices, currencies, and Treasury bonds.

Futures contracts are normally traded on special futures markets. The largest markets for futures are the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME), the London International Financial Futures Exchange (LIFFE), or the Eurex in Frankfurt.

The value of a futures contract can be explained by the relationship between futures and spot prices. This relationship is called cost of carry because the owner of a short position has always the opportunity to buy the underlying asset immediately after the closing of the futures contract by paying the spot price and carrying the asset until the settlement date.

The cost of carry consists not only of carrying charges but also of financing costs. Financial assets do not only have cost of carry but they also deliver cash inflows deriving from interest or dividends.

If the futures price is larger than the spot price plus the cost of carry, arbitrage opportunities arise by getting into a short position and by immediately buying the underlying on the spot market. If the futures price is smaller than the spot price, selling the underlying and getting a long position in the futures market would also deliver an arbitrage opportunity.